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Monday, August 23, 2010

Salary in a pre-revenue be or not to be?

Dad and I were working on a deal not too long ago and he made the comment that:

"a deal where one party can succeed where the other party fails pretty much guarantees that is what will happen, but if a deal is set up where everyone has to succeed for anyone to succeed, then it has a chance."

At the time we were talking about a deal that just didn't feel right, even though there was a lot to like. Ultimately, we passed on the deal and the founders moved on to another investor I know (who drove a different deal altogether), but I was frustrated that we couldn't put it together. I never want to see a deal fail to launch simply because of deal structure, or worse yet, a deal fail because of poor structure, but it happens all the time and I think Dad hit on a pretty common reason.

Often in start-ups, I see deals where the founder(s) has spent a lot of time developing from idea into a legitimate business opportunity and is ready to monetize that effort or they are ready to jump into the business full time and need to replace the income from their job.

The scenario usually is played out with a founder inserting a "living wage" salary into the pro-formas and hoping to raise enough money to cover it and the launch plan. Unfortunately, that salary creates a form of exactly what Dad was talking about...all the future risk of failure is on the investor because the founders are now covered (so long as they get a new job lined up before the company goes belly up). With that arrangement, until the company is cash flow positive the founder and investor will be out of sync, which inevitably leads to tension. Even most novice investors will sense that likely outcome and shy away...maybe to the point of not doing the deal, even on a good core opportunity.

A few other (and more investor friendly) options are:

1. The founder receives only a percentage of revenue (up to his salary level); or
2. the founder receives salary, but only out of net cash flow of the business; or
*(That still could leave open the possibility of encouraging a lifestyle company that doesn't ever net much to the investor, but that is a lot better than encouraging a full flop.)
3. founders and investors split any net cash flow (splits can vary).

This is not to say that no deal should have pre-revenue salary for the founders, because some deals just cannot get done any other way, but it is always something that needs to be carefully considered and probably avoided unless it is truly necessary.

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